1. 1 Top 15 Tax Issues Every Corporate Lawyer Should Know About ABA Business Law Section Annual Conference April 12, 2008, Dallas TX Saba Ashraf, Troutman Sanders LLP Ethan Millar, Alston & Bird LLP © Saba Ashraf and Ethan Millar 2008

2. 2 FEDERAL TAX ISSUES

3. 3 Introduction Basic Building Blocks  Rates of taxes  Types of entities  Goals Getting Initial Interest in Entity – Taxable? 1. How to Get founders stock tax-free in corporation (including 83(b) elections) 2. How to get founders and others interest in a partnership/LLC tax-free 3. Getting stepped-up tax basis when buying partnerships/LLCs

4. 4 Common Issues in Buying and Selling Entities 4. Getting stepped-up tax basis when buying corporations (338(h)(10) elections) 5. Acquisition of cash method corporation can result in unexpected income 6. How to structure tax-free reorganizations and other combinations of corporations 7. Pitfalls in mergers for cash 8. Earn-outs & escrows can result in taxable income prior to actual receipt of cash 9. Preferred stock issues

5. 5 Getting Initial Interest in Entity

6. 6 Issue 1: Getting Founders Corporate Stock Tax-Free Just because founder is getting stock does NOT mean it is tax-free – must meet several requirements Basic requirements for a 351 transaction Applicable to S corporations and C corporations Can be an issue if new person contributing appreciated property comes in after entity already formed. Contribution of services does not qualify  Solutions: Low valuation If stock is restricted, 83(b) elections. Must be made within 30 days.

7. 7 Issue 2: Getting Founders and Others Interest in Partnership/LLC Tax-Free Much greater possibility for achieving issuance on a tax-free basis. Possible, on formation or if pre-existing entity No 80%, or control requirements But, MUST be a profits interest only and not a capital interest Difference between capital interest and profits interest

8. 8 Common Issues in Buying and Selling Entities

9. 9 Issue 3: Getting Stepped-up Basis When Buying a Corporation: 338(h)(10) Elections Target, target’s shareholder and buyer must all be corporations Available only:  S corporation target  Corporate target that is 80%+ subsidiary of another corporation Pitfalls  Section 1374 – S corp with C corp history  Differences between inside and outside basis Difference between a 338(h)(10) and “regular” 338(g) election  When does a regular 338 election would make sense?

10. 10 Issue 4: Getting Stepped-up Basis When Buying Partnerships/LLCs Purchase of 100% of partnership treated as purchase of assets; results in stepped-up tax basis Purchase of less than 100% can result in stepped-up tax basis too – 754 election

11. 11 Issue 5: Acquisition of Cash Method Corporation Can Result in Unexpected Income. Cash Method of Accounting Accrual Method of Accounting 481(a) adjustment Be sure responsibility is placed on seller in acquisition contract

12. 12 Issue 6: Tax-Free Reorganizations and Other Combinations of Corporations Just because consideration consists of stock doesn’t mean there is tax-free treatment on receipt Various requirements have to be met in order to be sure it is tax- free, including:  40% stock/80% stock/100% stock  Can’t use certain types of preferred stock  Voting stock  Substantially all requirement – issue may arise if target has recently made a distribution Generally, can’t have a tax-free reorg in which LLC is acquirer or target. This one is pretty much for corporations What do you do if you don’t have the requisite amount of stock?  Double Dummy Structure  Requirements  May be burdensome for non-tax reasons

13. 13 Issue 7: Pitfalls in Mergers for Cash – Be Sure To Use Correct Structure Reverse Subsidiary Mergers – treated as stock purchases:  No target level tax; only tax to sellers  338(h)(10) elections possible if other conditions met Forward or Forward Subsidiary Mergers  Shouldn’t ever be done  Result in corporate level and shareholder level tax  Unless contract around it, the corporate level tax turns into buyer’s problem.

14. 14 Issue 8: Earn-outs & Escrows Can Result in Tax at Closing Just because you don’t receive consideration at closing doesn’t mean you automatically get to defer taxable reporting on that portion of merger consideration. Requirements for Installment Method Reporting How to structure to be able to report on the installment method.

15. 15 Other Issues Related to Investments

16. 16 Issue 9: Preferred Stock Issues If redemption price exceeds issue price  gives rise to “Preferred OID” – essentially redemption premium must be taken into income over life of the preferred stock Issue can arise if preferred stock has accrues unpaid dividends which are paid upon redemption Solution: Get out of definition of “preferred stock.”

17. 17 STATE TAX ISSUES

18. 18 Introduction 10.State Conformity to Federal Law 11.Nexus 12.Apportionment and Allocation 13.Transfer Pricing Issues 14.Non-Income Taxes 15.Unclaimed Property

19. 19 Issue 10: State Conformity with Federal Laws Most states generally conform to the federal rules  Most states use “federal taxable income” as the starting point for computing “state taxable income”  Other states adopt stand-alone provisions that attempt to “mirror” the provisions in the Internal Revenue Code (IRC)  Automatic vs. periodic conformity  Check-the-box rules Common exceptions:  Treatment of affiliated groups  Treatment of LLCs or S corporations  Net operating losses  Depreciation

20. 20 Issue 11: Nexus Constitutional restrictions on state’s ability to tax:  Due Process Clause: there must be “some definite link, some minimum connection between the state and the person, property or transaction it seeks to tax”  Commerce Clause: there must be a “substantial nexus” between the state and the taxpayer Physical presence may be required for income tax purposes (it is required for sales/use tax purposes) Nexus may be established by activities of affiliates if the activities are “significantly associated with the taxpayer’s ability to establish and maintain a market in the state” (“attributional nexus”)

21. 21 Issue 11: Nexus State statutes defining “nexus” are generally very broad, and thus do not provide taxpayers significantly more protection, if any, than is already available under the Constitution Nexus may be created by various types of activities  Ownership or lease of tangible property in the state  Presence of employees or independent contractors in the state  Deliveries of products into the state  Deriving income from intangibles that are used in the state  Activities of affiliates  Issuing credit to persons in the state  Registering to do business in a state  Maintaining bank account in the state

22. 22 Issue 11: Nexus Federal statutory restrictions on state’s ability to tax: Public Law 86-272 (15 U.S.C. § 381)  No income tax nexus if the taxpayer’s only activities include: Solicitation of orders for tangible personal property Activities that are “entirely ancillary” to solicitation Orders are sent outside the state for approval/rejection Orders are shipped from outside the state  Applies only to net income taxes

23. 23 Issue 12: Apportionment and Allocation If a corporate taxpayer is doing business in only one state, then the corporation is subject to tax on its entire income by that state If a corporate taxpayer is doing business in multiple states, then each state may tax the corporation on:  The corporation’s income that is “allocated” to that state, and  The corporation’s income that is “apportioned” to that state Establishing the right to apportion

24. 24 Issue 12: Apportionment and Allocation Allocable income  Includes non-business, or investment-type income  In general, may include dividends, interest, rents, royalties, and capital gain if not earned as part of the corporation’s regular business operations  Income from tangible property is generally sourced to, and taxed by, the state in which the property is located  Income from intangible property (e.g., stock, IP) is generally sourced to the state in which the corporation has its commercial domicile (i.e., its principal place of business)

25. 25 Issue 12: Apportionment and Allocation Apportionable income  Includes all of the corporation’s business or operating income  Apportionable income is not sourced to a single state, but is rather divided among the states according to apportionment formulas  States often have different apportionment formulas, which will generally result in the corporation being subject to tax on either more than or less than 100% of its total business income

26. 26 Issue 12: Apportionment and Allocation Non-uniformity in state definitions of “allocable” income and “apportionable” income can lead to “traps” for taxpayers, but also to planning opportunities  Some states treat certain types of income (dividends, interest, etc.) as allocable even if earned as part of the corporation’s regular business operations  Some states treat gain from liquidations as allocable income and some states treat as apportionable income

27. 27 Issue 12: Apportionment and Allocation Uniform Division of Income for Tax Purposes Act (UDITPA)  Apportionment formula = the average of three equally- weighted factors: property, payroll and sales Property factor: the percentage of the taxpayer’s total property that is located within the state Payroll factor: the percentage of the taxpayer’s total compensation that is paid to employees located within the state Sales factor: the percentage of the taxpayer’s total gross receipts that are sourced to the state  Most states have either adopted the UDITPA formula or a similar formula that double-weights the sales factor

28. 28 Issue 12: Apportionment and Allocation  However, a growing number of states have adopted single- factor apportionment formulas based only on the percentage of total gross receipts that are sourced to that state  If a corporation has income that is allocable or apportionable to a state in which that corporation does not have nexus, then the income is not subject to tax by that state (“nowhere income”) To maximize “nowhere income”, corporations generally want to limit contacts with market states

29. 29 Issue 12: Apportionment and Allocation  There is considerable non-uniformity in how states compute the sales factor of their apportionment formulas: Meaning of “gross receipts” “Throwback” and “throwout” rules Sourcing rules for sales of services or intangible property  Most states have adopted a “cost of performance” rule, but often apply these rules quite differently  A few states have adopted marketplace-based sourcing

30. 30 Issue 12: Apportionment and Allocation  States also differ in how they compute property and payroll factors  Non-uniformity in state apportionment rules may result in “traps” for taxpayers, but can also lead to planning opportunities Incentive to be based in a state that has not adopted a “throwback” (or “throwout”) rule Incentive to be based in a state that has adopted marketplace- based sourcing for income from services or intangibles Incentive to be based in a state that apportions based entirely on sales/gross receipts, or that at least weights the sales factor more than property and payroll factors

31. 31 Issue 13: Transfer Pricing Issues Typical state tax transfer pricing strategy:  Operating company forms subsidiary in no-tax state and transfers intangibles to the subsidiary in a tax-free transaction  Subsidiary licenses the use of the intangibles to the operating company for a royalty payment  Operating company receives a deduction for the royalty in the state(s) in which it does business, while the subsidiary is not subject to tax on the royalty income

32. 32 Issue 13: Transfer Pricing Issues  Subsidiary may also loan royalty income back to operating company Operating company receives deduction for interest paid to subsidiary Subsidiary not subject to tax on interest income  Other similar strategies: Manufacturer sells products to affiliated distributor (either manufacturer or distributor located in no-tax state) Taxpayer receives management or other services provided by an affiliate located in a no-tax state

33. 33 Issue 13: Transfer Pricing Issues  States have sought to disallow the state tax benefits from these structures in different ways: Mandatory combined reporting Use of IRC § 482-type provisions Adjustments to state apportionment formulas Aggressive “nexus” theories “Sham” transaction doctrine Add-back statutes – but may either be too broad or too narrow

34. 34 Issue 14: Non-Income Taxes Sales/Use Taxes  Apply to transfers of tangible personal property  Do not apply to intangible property  Typical exemptions Occasional or casual sales Sales for resale Manufacturing equipment Reorganizations  Nexus issues – physical presence is required  Check-the-box rules do not apply  Example of planning opportunity: “drop-kick” transactions

35. 35 Issue 14: Non-Income Taxes Real Property Transfer Taxes  Apply to transfers of real property May include leasehold interests in some states  Some states apply to transfers of a controlling (or other) interest in an entity holding real property  Many states exempt transfers to wholly-owned subsidiaries  Check-the-box rules do not apply

36. 36 Issue 15: Unclaimed Property All states have adopted unclaimed property laws that require holders of unclaimed intangible property to report and remit that property to the state Purpose of unclaimed property laws is ostensibly to reunite owners with their missing property  Unclaimed property laws are therefore “custodial” in nature rather than “true escheat” laws (state derives its rights from the owner of the property)  Nevertheless, many types of property either are not returned to the owner or cannot be returned to the owner As a result, most states now view unclaimed property as a significant source of revenue

37. 37 Issue 15: Unclaimed Property Most unclaimed property laws apply broadly to any type of intangible property that is “held, issued or owing in the ordinary course of business”  Unclaimed wages  Customer/vendor credit balances  Unredeemed gift cards  Uncashed rebate checks  Unclaimed dividends  Unclaimed royalties  Unclaimed deposits/prepayments  Unclaimed employee benefits Property is generally “presumed abandoned” 3-5 years after the property originally became due and payable, although the period can be shorter for certain types of property (e.g., wages)

38. 38 Issue 15: Unclaimed Property In general, the unclaimed property must be reported to the state in which the last known address of the owner of the property is located, as set forth on the books and records of the holder (“first-priority rule”)  Most states do not require holders to record this information, but provide that if the information is recorded, it must be retained by the holder for a period of at least 10 years after the property becomes reportable If the holder does not have a record of the last known address, then the state of the holder’s “domicile” (its state of incorporation, for corporate holders) may claim the property (“second-priority rule”)

39. 39 Issue 15: Unclaimed Property Most states do not have statutes of limitation for claiming unclaimed property  Delaware goes back until 1981 (or date business was formed, if later)  Even if owner’s claim is barred by statute of limitations, state may still claim property If business does not have records for prior periods, states will generally try to estimate the amount of unclaimed property for those periods using extrapolation or other techniques  State of domicile will generally claim these amounts as owner-unknown property States use third-party, contingent fee auditors which may represent multiple (40+ states) simultaneously

40. 40 Issue 15: Unclaimed Property What can you do?  Just start filing Include past due unclaimed property in initial report Risky – invites an audit  Voluntary disclosure agreements Limit look-back period Waiver of penalties and/or interest  Negotiation with auditors Contingent fee, multi-state audits may be unconstitutional State estimation techniques may not be permitted by statute or may not produce an accurate estimate Some “liabilities” on books may not represent actual obligations, but burden of proof is generally on the holder to show the books are not accurate Federal preemption may apply in some cases (e.g., ERISA)

41. 41 If you have questions or for more information, please feel free to contact us at: Saba AshrafEthan D. Millar Troutman Sanders LLPAlston & Bird LLP 600 Peachtree Street, NE1201 W. Peachtree Street Atlanta, GA 30308Atlanta, GA 30309 (404) 885-3925(404) 881-4252 saba.ashraf@troutmansanders.comethan.millar@alston.com